HEAD & SHOULDERS

The S&P 500's 90-Minute Head And Shoulders Top

03/22/05 11:07:24 AMby David PennAs the S&P 500 breaks down in mid-March, a growing positive stochastic divergence in the 90-minute chart suggests a bounce may come sooner than later.

Security:$SPXPosition:N/A

Are some chart patterns so obvious that not only are they not traded, but also no one makes any noise afterward when these patterns work out almost exactly the way they are supposed to?

That's my reaction to the nonreaction by traders and investors toward the head and shoulders top in the S&P 500--a bearish chart pattern that became visible on intraday charts during the late February to mid-March time frame. As shown in Figure 1, the head and shoulders top was borne specifically out of the mid-February correction--the rally from which built the left shoulder of the head and shoulders top late in the month.

The head of the pattern was created by the early March advance and subsequent decline, with the bounce off of support at 1200 (the "neckline" of the head and shoulders formation) helping create the right shoulder of the head and shoulders pattern near the middle of March.

Based on the formation size (approximately 30 points), traders looking at this picture of the S&P 500 could expect a decline to the 1170 area (formation size subtracted from value at "neckline"). So far, the market has moved aggressively toward that minimum downside objective, recently coming within 10 points of the 1170 mark.

Figure 1: As the S&P 500 plunges from a head and shoulders top toward its minimum downside objective in this 90-minute chart, a positive stochastic divergence appears to be building. The combination of a completed downside from the H&S top and a divergence-induced bounce could send the market higher in a very short period.

While reaching 1170 would not represent a new low for the year--a new low that many traders and technical analysts are watching with bated breath, it would represent a nearly 5% drop from the March 7th peak just shy of 1230. A 5% drop may not in all circumstances suggest a sharp correction. But a 5% drop in one month certainly does. Nevertheless, rather than salivating over the prospect of further, post-1170 losses, would traders be better off preparing for a reversal in the S&P 500's fortunes?

Plenty has already been said of the perils of picking bottoms, so I'll dispense with the usual precautions here. But the growing bearishness in the market (and in society at large as well, for that matter) means that the time for plotting further declines might be giving way to the time to begin planning for the inevitable bounce and--further--to prepare for the possibility that the inevitable bounce might turn into a sustainable move higher.

To what can these intimations of bullishness be attributed? I can't help but focus on the growing positive stochastic divergence between the 90-minute S&P 500 and the 7, 10 stochastic. The last time the 90-minute S&P displayed a positive stochastic divergence was during the mid-decline bounce on March 14--a bounce that might have netted particularly nimble intraday traders a few points.

However, a number of factors contribute toward a (gulp!) "This-time-is-different-attitude." First, the decline is another week, and other 20 points, older, more mature, and more ripe for reversal than it was after its 30-point decline from March 7 to March 14. Second, the positive stochastic divergence is more pronounced than the previous one, with the length of the moving average convergence/divergence (MACDH) suggesting that the relative strength between bulls (red bars above the zero line) and bears (green bars below the zero line) is moving closer to even. Compare this with the way the MACDH looked earlier in the decline, with massive green bars below the zero line and few, if any, red bars above.

Whether the reversal is tradable at this point is any trader's guess. Interestingly, top technical analyst Helene Meisler, who writes for TheStreet.com, last week penned an article titled, "Don't Miss Maximum Oversold Tuesday," referring to the potential of a bottom on Tuesday, March 22 (also the date of a Federal Reserve board meeting, by the way). Traders can decide for themselves whether Meisler's analysis is compelling (I find it so). But what is important at this juncture is that bears not become too greedy with the spring time declines that the market has provided, and that bulls not become too despairing--lest they not see the market turning back toward the positive at precisely the moment the market seems least likely to do so.